Faulty Wall Street Assumptions

Investors have to take some personal responsibility for their own actions, but one of the reasons so many people struggle with their investments is because many in the field of finance tend to perpetuate myths, rules of thumb and assumptions that just aren’t true.

Here are some that come to mind that can be harmful to those outside of the financial arena who are just trying to understand how things really work:

Investing is about finding new opportunities and security selection. In reality, new ideas and security selection are overrated. Portfolio management is really about risk management and portfolio construction. If you can’t get these things right it won’t matter how many new opportunities or stock picks you come across. Those are just tactics, not a portfolio.

200 page quarterly reports are a good idea. Charlie Munger once said, “Any time anybody offers you anything with a big commission and a 200 page prospectus, don’t buy it.” The same could be said about advisors, consultants or money managers who supply endless pages of performance or portfolio reviews. I’ve seen countless quarterly performance reports in excess of 100 pages. Who reads these things? They’re basically a way for a firm to say, “Look, we’re doing something on your behalf, even if it’s worthless busy work you’ll never bother reading anyways.”

Clients want to be impressed. Finance people have a nasty habit of using jargon to talk over people’s heads under the assumption that clients are looking to be impressed. Some probably are, but most people really just need a better understanding of the complexities involved with the markets and their own investments. It’s more impressive when you can communicate your message in a way that anyone can understand.

People care about risk-adjusted returns. The relationship between risk and reward is one of the most important ones to understand in all of finance, but like all good things, it can be taken too far. Investment people place a high premium on risk measurement, but not enough on actual risk management. Just because something looks good in a formula does not mean it will help someone achieve their financial goals. Yes, volatility matters but you can’t become a slave to some meaningless risk-adjusted return formula because it looks good in a textbook.

Intelligence is all that matters. One of the finance industry’s biggest failings is many blindly assume absolute brilliance is all they need when it’s really a relative game. There are plenty of smart people who are terrible investors because they can’t admit their own limitations. Intelligence is never in short supply on Wall Street, but the correct temperament is.

You have to have an opinion about everything. Some money managers just can’t help themselves and have to predict what’s going to happen with the Fed, the election, interest rates, the price of gold, who the winner on the next season of the Bachelor will be, etc. It’s OK to have a ‘too hard’ pile or simply admit you don’t know what’s going to happen at all times.

People need certainty. While people may crave certainty, what they really need is an honest assessment of the current situation and the prospects for the future. There’s no room in the financial markets for always or never, 0% or 100%. It doesn’t work that way. The best you can do is perform an assessment on future probabilities and scenarios, but nothing is ever set in stone.

Complex markets require complex solutions. To me, this is one of the most damaging myths out there for most investors. The simpler, the better (with the understanding that simpler does not mean easier). There are no extra points for degree of difficulty.

Past performance is all that matters. Past performance always requires context — investment style, market & economic environment, assets under management (then & now), the current situation, how returns were calculated, the amount of risk involved to get said performance, fees, luck, skill, future prospects, the process employed, etc. While the markets can be something of a running scoreboard of your investment decisions, you always need to provide context around historical returns.

Clients need more choices, more ideas, more products, more portfolio changes, more everything. Nope. Less is more. The best in this business know how to pay attention to fewer and fewer things — and only the ones that matter.

You need a repeatable process. I hear this one all the time. And while I agree that a repeatable process can be helpful, it’s an incomplete solution. What really matters is your discipline to follow a process. I’ve seen many a “repeatable process” that gets changed because something doesn’t go as planned. A process only works if you’re able to follow-through with it and have repeatable actions yourself.

Not everyone in finance works on Wall Street. I’ll call myself out on this one. People tend to lump everyone in the finance industry together as if there’s one big entity called “Wall Street.” There are plenty of great people who work in finance. Most firms just need a change in culture and incentives.

Now go talk about it.

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BEN CARLSON, CFA

A Wealth of Common Sense is a blog that focuses on wealth management, investments, financial markets and investor psychology. I manage portfolios for institutions and individuals at Ritholtz Wealth Management. More about me here.

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